Explaining the rhythm of the FX markets each day

Menu

Shuttered

With government here being shuttered
The question that’s lately been muttered
Is will the impact
Leave growth here intact?
Or will the shutdown soon have sputtered?

As we begin a new week, political events are dominating the market. Of course, Friday’s US government shutdown is the big, ongoing news story and one which doesn’t seem set to end quite yet. The most disheartening thing that I read was that every week the government is closed results in a reduction in US GDP of between 0.1% and 0.2% for that quarter. It is disheartening to me because it demonstrates just how large the Federal government has become, a situation that is fraught with economic risks going forward, for example, when it ceases to work like now. Interestingly, the equity market certainly didn’t concern itself with the issue, continuing its rally on Friday, although this morning’s futures markets are essentially unchanged. Treasury bond prices have, however, continued their recent decline and the yield on the 10-year note has now firmly traded through the 2.627% level that was seen as a key point. I continue to look for Treasury yields to climb and expect 3.0% in the near future. The dollar, on the other hand, seems to be the one thing that has suffered from the shutdown, having fallen against all its G10 and most of its EMG counterparts in the session today. However, it remains to be seen if this is specifically due to the shutdown or if there are other issues involved.

The other political story with some traction is from Germany, where the center-left SPD has voted to enter negotiations with Chancellor Merkel’s center-right CDU/CDS to once again form a grand coalition government. This is the pairing that had been in charge prior to the election, and despite the fact that both parties lost a significant number of votes to more extreme voices, I will wager they will come to some agreement. The aphrodisiac of power is far too strong for those who have tasted it to concede it willingly! Arguably, this has helped underpin the euro to some extent this morning as any reduction in uncertainty over the leadership in Germany, and by extension the entire Eurozone, will be seen as a positive.

In fairness, there is one other political story that has had a direct impact on the relevant currency, and that has been in South Africa. It seems that President Jacob Zuma is closer to being removed from office by his ANC party and likely to be replaced by Deputy President, Cyril Ramaphosa, a successful businessman there. Given the problems within the economy there as well as the recent attempts by Zuma to change rules in order to entrench his own status as president, the idea that he will be removed shortly has been warmly greeted by the market. This morning, the rand has rallied a further 1.25%, taking the appreciation since the middle of November, when Ramaphosa was first mooted to take over, to more than 17.5%.

On a different tack, I want to highlight something that I have observed during the first few weeks of 2018. It seems that almost everyone with a forecast has said that while a recession is clearly going to occur at some point, and an equity market correction along with it, 2018 will not be the year for this to occur. The combination of growth momentum and the recently passed tax legislation will serve to insure yet another year of banner results. My concern is that markets are funny things, often perverse in their behavior relative to broad expectations. In this context, that implies to me that with virtually every expectation that the ‘overdue’ recession/correction is not coming this year, I fear that is exactly what will happen. Markets have a habit of reacting far more quickly than economists, so my antennae are definitely tingling.

Away from the politics, and into a week with relatively limited economic data (which may be delayed due to the shutdown), we do have two key central bank meetings. Tonight the BOJ meets although expectations are for no policy adjustments. Of course, we just saw a subtle change in their JGB buying last week, which had a significant impact on markets. Given inflation in Japan remains well below the 2.0% target, it seems highly unlikely they will do anything here. But market chatter continues to focus on a growing concern by some BOJ members that QE is beginning to have negative consequences on the economy leading to excess leverage and potential future problems.

Then on Thursday the ECB meets and there the situation is more nuanced. While there is no expectation for any actual policy changes, the question of how forward guidance will evolve has come to the fore recently. This is due to the fact that at the December press conference, when asked about discussions on QE changes, Signor Draghi emphatically explained that there were no discussions on the topic. However, the recently released Minutes showed that there were, in fact, numerous discussions on the topic. So you can be sure that the press conference on Thursday will be quite spirited. The one thing that is clear is that the hawks on the ECB remain in the ascendancy, and that will continue to help underpin the euro. Remember, my stronger dollar thesis remains based on the idea that the Fed will be forced to tighten policy more aggressively as inflation in the US accelerates, while the ECB will wind up doing a bit less as inflation there continues to lag. But right now, the narrative remains the other way round and the euro continues to rise accordingly.

Here is a quick look at the planned releases for this week:

Wednesday

Existing Home Sales

5.70M

Thursday

Initial Claims

235K

New Home Sales

675K

Leading Indicators

0.5%

Friday

Q4 GDP

3.0%

GDP Price Index

2.3%

Durable Goods

0.9%

-ex Transport

0.6%

So the key data is due Friday, but if the government shutdown persists, it may well be delayed. My take is that is indeed what will occur, and therefore markets will be focused on the non-US stories, most notably the ECB on Thursday. For now, the dollar remains under pressure and I don’t see a catalyst to change that on the horizon.